By David Sterman
General Electric (NYSE: GE) is back. Its shares have more than doubled from the early 2009 swoon to near $16 and profits have begun to rebound. Then again, maybe not. Shares never traded below $30 in the middle part of the last decade, and now trade for just half that. And that's understandable. Analysts think GE's revenue base will shrink -2% this year and another -2% next year. In fact, annual sales are roughly $30 billion lower than they were in 2008. The Jack Welch era is an increasingly distant memory.
About 3,000 miles from GE's Connecticut headquarters sits another lumbering giant: Microsoft (Nasdaq: MSFT). The software titan can at least boast moderate sales growth this year and next, as it squeezes yet more cash flow out of its legacy Windows operating systems. But investors are now dubious of "Mister Softee" as well. Shares have lost half their value in the last decade.
Both companies suffer from a pair of factors: An unwieldy mix of disparate operating divisions, and leadership successors that have proven no match for their predecessors.
But perhaps it's a bit unfair to blame GE's Jeff Immelt or Microsoft's Steve Ballmer, as the decks may be stacked against them. Both of these companies are simply too large to navigate in a fast-changing economy. The only solution is to carve them up into much smaller boats that can more easily navigate the channel and avoid the shoals.
Illusory Benefits
Both companies will tell investors that they derive a great deal of synergies from their operations. GE's capital arm can finance a large purchase of its railroad engines. And Microsoft's online gaming division can be seamlessly incorporated with its MSN Live home page. In reality, all of the divisions operating at these two titans enjoy very few synergies. But to separate any divisions would prove to be a time-consuming and distracting process, so the companies simply muddle through, while rivals steadily take market share.
GE
GE has built five outstanding business segments, all of which hold their own in downturns, and flourish in upturns. Its finance division, which was much maligned a few years ago, is actually run more responsibly than traditional Wall Street financiers. In the economic downturn, the company took a hit on some consumer and real estate exposure, but not nearly to the extent that rivals did. GE Capital is now healthier, but somewhat hampered as management seeks to stabilize results and avoid the wild profit swings that finance arms often see.
In a similar vein, the Industrial segment continues to crank out cutting-edge equipment and should be a key player in the global move to boost energy efficiency and reduce fossil fuel dependence. But it's a cyclical business and typically deserves a lower multiple than true growth businesses.
Ironically, I thought Mr. Immelt had the right strategy when he took the reins early this decade. At that time, he suggested that GE shed slower-growth divisions and re-invest the proceeds in faster-growing segments. Thus, GE Water and GE Healthcare were born.
To be sure, both of those segments have had growing pains, but demographics tell it all. Clean water will likely be an ever-scarcer commodity, and an aging global population will keep us consuming more health care technology. Trouble is, those exciting divisions are shrouded under a dowdy corporate umbrella, and would likely garner impressive P/E ratios (and better returns for shareholders) if they were stand-alone businesses.
Microsoft
While GE can credibly claim that at least some its woes are due to the tepid global economy, Microsoft has no such excuse. Tech rivals like Apple (Nasdaq: AAPL), Google (Nasdaq: GOOG) and Cisco Systems (Nasdaq: CSCO) all keep delivering exciting new products that yield more impressive growth rates. Microsoft, in contrast, is known for half-hearted attempts with its own MP3 players, smart phones and tablets. Only the Xbox stands out as a clear winner for Microsoft -- an exception to the rule.
Reports out of Microsoft often cite a stilted bureaucracy that can stifle innovation. Yet innovation is what Microsoft -- and GE -- are known for. There's only one way to get that innovative spirit back: de-conglomerate. Throughout the 1980's, companies such as ITT, IBM, United Technologies (NYSE: UTX) and Honeywell (NYSE: HON) sold off non-core businesses, many of which went on to thrive as stand-alone entities.
In late July, Microsoft held a full-day seminar with the investment community. Analysts generally applauded the company's efforts to:
- Capture a bigger share of the cloud computing environment (which uses a wide range of networked computers in different locales to enhance storage and increase processing power).
- Extend the reach of the Xbox gaming platform by rolling out a fully-interactive system, known as Kinect.
- Try once again to be a relevant player in mobile phone software.
To underscore that investors will never fully appreciate Microsoft while it is so large and disparate, the company posted fairly impressive fiscal fourth quarter results on July 23rd, yet shares have drifted a bit lower since then. In fact, Microsoft has surged past profit forecasts by at least +10% in three of the last four quarters, but shares have been generally unresponsive.
The solution
The recipe is simple. Methodically sell a few divisions of each company, and saddle each of these spin-offs with a reasonable amount of debt. Then re-invest some of the proceeds into the remaining businesses to push them back to the forefront of innovation. Following up on the examples of GE Water and GE Healthcare, GE could use some money to start a new segment that has high-growth opportunities and plays to GE's strengths. And all of the rest of that cash? Long-suffering investors wouldn't mind a large one-time dividend that says, "thank you for all of your patience."
Sooner rather than later, the board of directors at these companies may seek to make a leadership change. That would be a fine time to reassess these respective conglomerates. They may well find that smaller is better.
Shares of Microsoft trade for less than 10 times projected (June) 2012 profits. The multiple is even lower when you exclude the company's $38 billion net cash balance. Yet some of Microsoft's divisions such as entertainment/devices (growing +27% year-over-year) and its business division (+15% year-over-year growth) would surely fetch a higher multiple than that. To simply boost company-wide sales by +10% during the next year, as analysts expect, is not enough to get the stock moving. Bolder action, such as sending some fledgling divisions out of the nest, is the more likely path to a higher share price.
For existing investors in these companies, you can be assured that these stocks represent strong value on a sum-of-the-parts basis, so there's no reason to be a seller at these levels. For investors who don't yet own these stocks, keep an eye out for any signs of willingness to make major structural changes. Once the Street gets wind of any intentions to unlock shareholder value more aggressively, funds could flock to these names.
